May 15, 2012

The Investor Edge from Europe

Here is a surprise for you. European leaders did better than your favorite pundit!

They will also do better in the future.

For the last two weeks the dollar has moved higher versus the Euro and stocks have moved lower -- almost an unbroken string.

The European story fit nicely with trader pre-conceptions about selling in May, following the pattern of the last two (count 'em!) years, and the lack of more QE.

Setting this up was a revival of the disaster scenario -- a 2008-style Lehman like event where banks would topple and the financial system would crumble. Everyone's favorite conspiracy website teed this up by multiple posts predicting a continent-wide bank run. The leading CNBC commentators are bombarded with email and tweets from traders. In the modern age, the tweeters influence the content.

The bank run story has gotten widespread play, with journalists all solemnly agreeing that a Greek exit from the Euro would be a disaster.

The traders and pundits see European leaders as clueless bozos who did not do what they thought was correct, and did not do it in the time frame they thought was right.

Let us put aside that many pundits sought austerity while many others advocated growth. They all agreed that leaders were wrong for ignoring their recommendations.

An Objective View

This is going to be difficult for most people, but try to be objective about the various parties in Europe. Here is the question:

Has delay and bargaining improved things? Let us start by considering it party by party.

Greece. Clearly improved. Negotiated a better deal on debt on round one, and in the bargaining for round 2. The citizens want to stay in the Eurozone and they want less austerity. They may well get both.

France. Much the same story. Some agreement to reforms followed by pushing back from voters.

Germany. Position improved from last year. There were concessions on political sovereignty and commitment to more austerity. Last year it was a cliff-diving scenario.

ECB. Better now. The ECB exacted concessions for austerity and structural reforms before agreeing to more liberal lending. This was much better than caving in a year ago.

IMF. Better now. By bringing together various European parties, the story was improved and the incentive for the rest of the world to participate was enhanced. The IMF has not yet reached the target in raising funds, but it is doing much better than it would have a year ago. Wasn't that when DSK had his problems?

Other Potential Investors. Also better now than a year ago. I am still expecting China and Middle Eastern sovereign wealth funds to join in. Why? Because it is in their self-interest to do so. Europe is China's biggest trading partner. No nation benefits from a European collapse. The terms for involvement are better than a year ago, and the concessions from the various parties are better.

Turning from the particular participants to the collective, are things better or worse?

In the best case, things are much better than a year ago. Banks have more capital. They have lending from the ECB, with the chance to profit on the spread.

In the worst case, things are also much better. The original Greek debt with the threat of CDS payoffs was a major systemic threat a year ago. Those debts were negotiated, and things are a bit different. There are various current paths for Greece. Whether it is an exit from the EZ or another discount on debt, the stakes are lower than a year ago.

Investment Lesson

This is a continuing story of compromise and negotiation. Each party is benefiting from the delay. So far, it has also helped the collective.

Those complaining about "kicking the can" have been wrong. Those criticizing European officials have been wrong. Those predicting disaster have been wrong. Do you see a pattern?

The mainstream media has a fixation for trader/pundits who have all of the answers, even if they did not take Poli Sci 101. They translate everything into how they would do it in their own business --- immediate and decisive action.

No matter that the recommended actions are in complete opposition, depending upon the political predispositions of the pundit.

Investment Conclusion

Markets can and do pursue irrational themes. You can almost guarantee that it will happen each year. When this occurs, the long-term, Warren Buffett style investor should be prepared to step up.

Mr. Buffett uses his own values and treats the market as giving him mis-priced opportunities. This is a concept that some investors understand in theory, but few can implement.

I have been following all of the Europe news closely. I will try to provide a range of useful perspectives in the next installment. At the moment, everything is on sale. I especially like cyclical stocks like Caterpillar that do not even emphasize Europe, technology stocks like Oracle, which has been very resistant to slowdowns, and growth stocks like Apple, which seems to be trading in line with the dollar.

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Comments

I really enjoyed this article on Europe. I don't really listen to or watch the mass media much so I didn't realize they were doing the hysteria thing on this.

I don't think this market downturn of the past few days really has anything to do with Europe or Greece though. I think it has something to do with the $2 billion trading loss at JP Morgan. The Greece/ Europe thing is not new, everything happening in the last few weeks has been obvious for months if not years.

So what is new? If JPM is admitting a $2B loss it means it is probably more like $20B to $200B and this is before any kind of default or crisis anywhere. Whatever is really going on there we can safely assume the public will be the last to know and it will only come out after all of the insiders have safely unloaded their stakes.

Having said that I totally agree with you that contrarian is the only way to go and if someone is not buying now, even for a bounce, then when?

ok Jeff, now i think i understand. If the EU had done nothing last year, all these countries would be in way worse shape than they are now (agreed).

My point, the trend is still bad for all the periphery. At some point they need to actually reverse the deterioration, not just make it better than it would have been...

Here is my counterfactual. If they had admitted in 2010 that the single currency was a mistake and used the bailout money to fund the transition costs back to national currencies, would they be better or worse off than they are now ?

I should not have characterized your comments as arguing that things were "fixed" across the pond. I wasn't being careful and I apologize for that.

I continue to think that the verdict of the markets, in lower risk asset prices, is telling us something, and it might be more profound than the wrongheadedness of traders, pundits, and the masses. I guess that's what has had me bothered -- you don't really address it, other than to characterize the moment as irrational mis-pricing.

Things may be (I think you would argue ARE) better than the worst they could have been. I get what you're saying, and I agree with the point. It is unassailable, frankly.

Angel -- You are not looking at the counterfactual. What would have happened without the actions of the last year?

The average person may not be able to think in these terms, but we should be able to.

Please read the line about Greece again.
Without the actions of the last year they would have been much worse off.
Furthermore, the current process may succeed in reducing austerity and getting more help to stimulate growth.

Jeff, sorry i can't see how a citizen/investor in spain or italy would think they were better off than last May. They have major losses on both their stock and bond portfolios, both economies are in recession, higher unemployment, missing their deficit targets and facing higher interest rates.

All the incumbent politicians in these countries are being voted out, which suggests to me that the citizens are not feeling that things are improving.

Massive ECB/LTRO intervention in December prevented (postponed?) a catastrophic collapse, but did not change the underlying trends.

Note, i still expect complete disaster for the euro. That forecast is based on my assessment that the periphery won't have enough nominal gdp growth to service their debt COMBINED with the euro-elite political agenda to maintain the euro regardless of the economic consequences.

I did not say that problems were "fixed satisfactorily." I said that each party got more of what it wanted through delay. That as the result of the actions Europe was better prepared than a year ago. I have also made it clear that this is a work in progress which would eventually include more pieces and more players.

I'm sorry you don't like this article, but it seems like you are interpreting it to say that "Europe is fine" when that is clearly not the point.

As to whether or not I am right in my forecast, I agree that it is "so far."

I hope that some have been enlightened by our discussion, but I have explained the concepts as well as I can, and I'm moving on.

We will quickly muddy the waters by mixing trading and investing concepts, and you know that. In trading, the price is correct, and the "masses" (trend) are typically correct until an inflection point. There's more of an investment case to make that things are "on sale" for a longer-term investor.

With respect to the argument I think you're making, you are correct that Armageddon has not occured. So you're "right," which seems to be important to you. That fact that markets are down in the EZ from 2011 to present, and also YTD in the case of most countries, does not support your contention that the problems are fixed satisfactorily. As I noted yesterday, we're close to roundtripping the crisis lows from last Fall. That's not a trivial point.

To state thngs simply, I think (as do some others) that you're waving a victory flag during the halftime show.

Interesting take. Thanks for forcing me to think in a different direction. ;) We need more views like these to remind us how easily we can get carried away with the negative sentiment. And good time for picking bargains.
Having said that I am still skeptical, as I think kicking the can strategy is nearing its end. Who is going to pay ultimately for all the mess? Big picture view: deleveraging has just only started in the US, to a lesser degree in Europe... More pain ahead, no matter what the sentiment is and how many LTROs or QEs we will have down the road.

Jeff, I don't understand how one would argue that things are better than a year ago for Spain and Italy, which are the eurozone's two biggest problems.

Italy and Spain are paying higher interest rates across the yield curve compared last year in May (exception, Spanish treasury bills).

Even their 2 year bonds are currently yielding 3.6 and 4.1 %, which for Italy is higher than trend nominal gdp growth prior to 2008.

The problem with the delay/bargaining strategy is that for countries which are eventually going to be forced to leave the euro, delay/bargaining means they end up with larger amounts of euro denominated debt to default on, which make the eventual costs of default higher for everyone...

Mr. Buffett has mentioned that he would be on the street corner selling pencils from a tin cup if this were correct! For long-term investors a key skill is recognizing when the market pricing is inaccurate -- whether too bullish or too bearish.

The current market reaction, which you can see daily if watching the news flow, is linked to a concern about a systemic failure resulting from bank runs in multiple countries. That makes it an important topic to consider.

You can go with the masses if you want, but I have done very well with a contrarian style.

The market reaction has been the market reaction...it has been neither excessive, as you declare, nor insufficient. It simply is what it is, and that is negative. The fact that there has been no Armageddon has not resulted in profits for a typical investor since the start of 2011, one not trading, and holding their requisite x-percent Developed International allocation.

As I look at the world, the choices are more nuanced than an either/or Armageddon, or whether I'm all-in or all-out to start May. Like you, I don't think Europe goes all Armageddon. That either-or setup isn't a catalyst to make money however. But I acknowledge that you're right, and no systemic meltdown has occured. That doesn't mean we're all-clear though. And cheap can get cheaper.

I really needed the rational reality check the article provided. It's amazing how quickly my mind followed the herd into the black-and-white "Europe is bad" mindset.
I think I'm a regular cynic of what the media is pushing. Jeff, your article was a timely reminder - keep questioning.

You're better than celebrating via the rearview mirror. We need to trade/invest what is, not what should be, or what was. The markets have been sliding for weeks, since the 3/31 top, on deteriorating macro from Asia-Pacific, and the re-brewing crisis in Europe. The US is losing momentum, not gaining. And we're only about 6-7% from roundtripping to the fall lows reached on EFA, my proxy for non-US developed. Long has been wrong, and sell in May has been correct. You are appearing to suggest something different, despite the empirical facts.

Hi Jeff,
those of us in the UK/Europe expressing this view are thin on the ground so your support is welcome! I agree with your points here. One of the things you highlight - the emergence of trader advocacy via blogs and twitter is becoming a major issue given that the mainstream media fail to discriminate on any form of quality control or skill set. Those of us who do go on CNBC et al. who do have a background in political analysis, economics, portfolio construction etc. etc. are all too familiar with the soundbite simplicity of the 24 hour news channels. It is also very agenda driven - everyone in officialdom is a fool - everyone in the market is a genius - those that lose money are victims of the fools but those who make money are brilliant. Funny how they have all failed to pick up on the JPM trade as being a leveraged, illiquid punt on double dip US recession gone wrong...